What Is a Discount for Lack of Marketability?

A discount for lack of marketability (DLOM) is a reduction in the value of an ownership interest in a privately held company to account for its illiquidity. Unlike shares of a public corporation that can be sold on a stock exchange, an interest in a private business cannot be converted to cash easily or quickly. This valuation adjustment reflects that an asset without a ready market is less valuable than an identical asset that can be sold with minimal delay. The DLOM is a percentage deducted from a company’s estimated value to compensate a buyer for the risks of an illiquid investment.

The Concept of Marketability in Business Valuation

The reason for a marketability discount lies in the difference between a marketable and a non-marketable asset. An ownership stake in a publicly traded company is highly marketable, as an investor can sell their shares through a broker and receive cash within a business day. This process is efficient due to the existence of a constant, active market.

In contrast, an interest in a privately held business has no established marketplace. Selling such an interest is a time-consuming process that can take months or years. The owner must actively search for a buyer, engage in negotiations, and incur professional fees for attorneys, accountants, and business brokers.

It is important to distinguish the discount for lack of marketability from the discount for lack of control (DLOC). While often discussed together, they address separate issues. DLOC applies to minority ownership stakes and reflects an investor’s inability to direct company policy. DLOM relates purely to the difficulty of converting the ownership interest into cash, regardless of whether it is a controlling or minority stake.

Scenarios Requiring a Marketability Discount

The application of a DLOM is a practical necessity in numerous financial and legal situations. Common scenarios include:

• Gift and estate tax planning. When a business owner transfers an interest to heirs, the value must be reported to the IRS on forms like Form 709 for gifts or Form 706 for estates. Applying a DLOM results in a lower fair market value, which can reduce the potential tax liability.
• Shareholder disputes and corporate litigation. In cases of a partner’s departure or shareholder oppression, courts must determine the fair value of the owner’s interest for a buyout. A valuation that includes a marketability discount is necessary to establish a price that reflects the interest’s illiquidity.
• Divorce proceedings. If a privately held business is a marital asset, its value must be determined for property distribution. Appraisers apply a DLOM to arrive at a realistic fair market value, ensuring the spouse retaining the business is not credited with a value that cannot be quickly realized.
• Employee Stock Ownership Plans (ESOPs). Federal regulations require ESOPs to have their stock valued annually by an independent appraiser. Since the company stock is not publicly traded, a DLOM is a standard component of the valuation process to determine the stock’s fair market value.

Factors Influencing the Discount Size

The size of the marketability discount is specific to the company and the ownership interest being valued. Appraisers analyze a range of factors to determine an appropriate discount, including:

• The company’s dividend policy. A company with a history of paying regular, substantial dividends provides a cash return to the investor, which can offset the impact of illiquidity and lead to a smaller DLOM.
• The terms of a shareholder or buy-sell agreement. An agreement that provides a clear path to liquidity, such as a mandatory buyout provision, can reduce the discount. Conversely, restrictive agreements increase the difficulty of a sale and support a larger DLOM.
• The company’s financial performance and outlook. A consistently profitable company with a strong balance sheet is more attractive and easier to sell, justifying a lower discount. A business with volatile earnings or high debt warrants a higher discount.
• The size of the ownership block. While distinct from the DLOC, a non-controlling minority interest is generally less marketable than a controlling interest, which can influence the size of the marketability discount.
• The prospect of a future liquidity event. If a sale of the company or an initial public offering (IPO) is likely in the foreseeable future, the expected holding period is shorter, which supports a smaller DLOM.

Methods for Quantifying the Discount

Valuation professionals use several established methods to quantify the DLOM, relying on empirical data and financial models. The two most recognized approaches are based on studies of restricted stocks and pre-IPO transactions, which provide a market-based foundation for the discount percentage.

One primary method involves analyzing restricted stock studies. These studies examine transactions in shares of public companies that are legally restricted from being sold on the open market for a period. By comparing the prices of these restricted shares to the market price of unrestricted shares on the same day, analysts can measure the discount investors demand for the lack of marketability.

Another accepted approach is the use of pre-IPO studies. This method compares the price of a company’s stock in private transactions before it goes public with the price offered in the initial public offering. The discount between the private transaction price (when the stock was illiquid) and the IPO price (when it became liquid) serves as a proxy for the DLOM.

The U.S. Tax Court case, Mandelbaum v. Commissioner, provides a legal framework for assessing the reasonableness of a DLOM. While the court did not endorse a single calculation method, it outlined a non-exclusive list of factors that should be considered. These factors serve as a benchmark for justifying a chosen discount. More complex approaches, such as option pricing models, are also used by some appraisers.

Substantiating the Discount

A substantiated discount for lack of marketability is necessary for a valuation to withstand scrutiny. Applying a generic “rule of thumb” or an average from a study without specific analysis is insufficient and likely to be challenged. A defensible DLOM requires a comprehensive business valuation report prepared by a qualified and credentialed appraiser.

A valuation report must document the rationale behind the selected discount. This involves a detailed narrative that connects the specific facts of the company to the chosen DLOM. The appraiser should explicitly discuss the factors considered and explain how they collectively point toward a higher or lower discount relative to benchmark data.

The report must also detail the methodologies used to quantify the discount, whether based on restricted stock studies, pre-IPO studies, or other models. It should explain why the selected methods are appropriate for the subject company and how the data was applied. This transparency is needed for the valuation to be persuasive. In a tax context, the burden of proof for a valuation discount falls on the taxpayer, and an inadequately supported DLOM can trigger an IRS audit and potential penalties.